By Andrew Marshall
By Chris Allbritton
ISLAMABAD, Dec 1 (Reuters) - August's catastrophic floods in Pakistan sharply raised the risk level in a country already contending with widespread insurgency, a feckless government and an economy propped up with aid.
The stock market more than doubled from lows hit last year during the global crisis, lost ground in recent months due to the impact of the floods, but has since recovered to flirt with yearly highs. Few foreign portfolio investors have significant holdings, and local investors tend to be less risk-averse.
Following is a summary of key Pakistan risks to watch:
THE IMPACT OF THE FLOODS
Pakistan's floods displaced millions of people, and destroyed crops and livestock. The government has estimated direct loss to the economy of almost ${esc.dollar}10 billion, far short of the initial damage estimates of ${esc.dollar}43 billion - almost a quarter of Pakistan's 2009/10 GDP. The IMF offered ${esc.dollar}450 million in emergency aid to cope with the immediate impact of the disaster.
But the longer term consequences also pose major risks for investors in the region and for geopolitical stability.
The competence of the government of President Asif Ali Zardari once again has been found wanting -- its response to the crisis was widely condemned as inadequate, and this was compounded by the fact that Zardari left the country during a critical period in the unfolding catastrophe for a visit to Europe that included a helicopter trip to inspect his French chateau. Popular anger with the government continues to grow, with the lack of basic services in the rural areas a source of great frustration. The military is seen as having provided a much more organised and efficient response, and the crisis has certainly strengthened the hand of the Pakistani armed forces in their perennial power struggle with civilian politicians.
But the greatest beneficiaries of the crisis may well be the Pakistani Taliban and other radical groups, which provided well organised aid to flood victims in several areas. With the civilian government weaker than ever and anti-government sentiment running high, this is a situation that extremist militant groups can exploit to increase their influence and territorial grip.
What to watch:
-- Political fallout. The damage to Zardari's government isn't over and winter is coming on. With millions still homeless, how badly will Zardari be damaged by popular anger at the government's response to the crisis? Will it allow the military even more autonomy from civilian control?
-- Economic impact. Growth was forecast at 4.5 percent for the current fiscal year, but because of the floods the central bank cut it to between 2 percent and 3 percent.
-- Security implications. To what extent will the misery, dislocation and anti-government anger caused by the floods allow extremist groups to gather strength?
INTERNAL SECURITY
Large swathes of Pakistan remain outside government control, run by the Taliban and tribal leaders. Last year's military campaign to roll back Taliban territorial gains saw some successes, but insurgents have shown they can launch major attacks in urban, industrial and commercial centres with relative impunity. The U.S. troop surge in Afghanistan could also cause more instability in Pakistan's border regions.
What to watch:
-- Ability of militants to launch attacks. Several assaults on military facilities in particular have shown the continued ability of Taliban militants to attack even protected targets. There is no sign of a sustained improvement in security despite offensives against the Taliban. Pakistan's markets have long grown accustomed to the level of violence and bomb attacks will not have a significant short-run impact on prices unless key government or military leaders are killed. Investors are more sensitive to attacks in Karachi, the commercial hub and home to the main financial markets, the central bank and the main port, but several recent bomb attacks did not spark heavy selling. Investment will be deterred by continued instability, with negative implications for long-term growth.
-- Safety of Pakistan's nuclear arsenal. Pakistan's poor record of preventing attacks on even secure military targets has raised concern that militants could penetrate a nuclear facility. Analysts say while there is minimal risk insurgents could get their hands on a nuclear missile, a potential danger is that they could steal some fissile material which could be used to build a "dirty bomb". This scenario would unsettle markets not just in Pakistan but also in India.
EXTERNAL SECURITY
Relations with India are in an uncertain phase. Talks between the countries' foreign ministers produced no progress and may even have moved relations backwards. Unrest in areas of Kashmir under Indian rule has raised tensions.
Washington has been trying with some success to persuade Pakistan to focus on the Taliban threat within its borders rather than the perceived external threat from India. But with many groups in Pakistan still sworn to launch more attacks in India, particularly over disputed Kashmir, there is constant risk of another sudden chill in relations. With two nuclear-armed powers facing off, there is also the risk an accident or misunderstanding escalates into major conflict. [ID:nSGE61501S]
Relations with Afghanistan could also be better. Afghan President Hamid Karzai called for NATO attacks on Taliban sanctuaries in Pakistan after the release of tens of thousands of classified U.S. military reports by the website WikiLeaks that appeared to implicate Pakistan's spy agency, Inter-Services Intelligence, in supporting the Afghan Taliban. Pakistan reacted with denials and fury.
What to watch:
-- Attacks in India. Any attack with Pakistani fingerprints could spark a serious confrontation, pushing down markets on both sides of the border.
-- Any sign of progress on talks. India has been reluctant to broaden the agenda to problems such as Kashmir until more is done in Pakistan to deal with those behind the Mumbai attacks.
GOVERNMENT EFFECTIVENESS
The government has limited control over the military, and has also been undermined by tussles with the judiciary. It has been relatively ineffective in tackling corruption and reforming the economy. President Zardari signed into law constitutional amendments transferring important powers he held to the prime minister and parliament, but this has done little to placate his enemies. His government remains weak and prone to splits.
Problems in formulating and implementing policy will continue to act as a drag on investment. The impact of the floods and continued violence in Karachi will only worsen the situation.
What to watch:
-- Changes in political balance of power. Markets will be watching manoeuvring by opposition parties and the military to gauge the possibility of a challenge to the government. Most analysts expect the government to remain in power for now, but distracted from reforms because of its focus on survival.
-- A December 2009 decision by the Supreme Court that a 2007 amnesty decree was unconstitutional has opened some close allies of Zardari to charges, further weakening the government and distracting from policymaking. Zardari, though protected from old charges by presidential immunity, could face legal challenges to his eligibility to be president. Such challenges would likely unnerve investors, not because Zardari is seen as indispensable but because political turmoil would distract the government from efforts to improve security and the economy.
ECONOMIC REFORM AND INFRASTRUCTURE
Pakistan's economy is propped up by an ${esc.dollar}11 billion loan programme from the International Monetary Fund as well as aid from donors like the United Sta
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